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The Best Financial Crisis Ever

Global China Financial Forum Key Note Luncheon Address by John Pattison Hilton Hotel, Markham 18 October 2008
I am very honoured to be invited to your luncheon today. It is a particular pleasure to have guests from the Middle Kingdom. I first went to China in 1985 and on every return visit it is amazing to see not only the changes but the acceleration of the rate of change. This is now an exciting, and somewhat uncertain time in financial markets. If I made an attempt at humour I would suggest that the financial crisis has been the result of a conspiracy. As we know the United States election process goes on far too long and the credit crisis was designed specifically to take people’s minds away from the election. I am going to speak today about the global financial crisis. In doing so I am going to relate this to the challenges facing China. These are very distinct to the current problems in the Western world but there are some links that are worth noting. This is without doubt the best financial crisis that we have ever seen and surpasses in depth and complexity the much simpler, indeed inferior, bank crises of the 1930s.

The Financial Crisis
Why is this a great crisis? First it is important for everybody to realize that finance aspires to be a science but is an art, sometimes a black art. By comparison, a mechanic who fixes the engine of an automobile does a better job of fine tuning the performance of the engine than supervisors of banks can do in managing the economy. This is not because they are bad or incompetent. It is mainly related to two factors: (1) Human behavior is unpredictable and financial fear is a strong and wild stimulus. (2) What people often ignore, even people in key central banking and supervisory jobs is that financial markets behave totally differently in good times and in bad times. In good times the performance of different markets tends to be somewhat unrelated and thus a diversified portfolio offers some protection. But in bad times, fear causes people to buy and sell assets in ways that cause previously unrelated asset behaviour to converge into cumulative downward spirals. This is fascinating but not pretty, it is interesting without being amusing. Second, this crisis has lessons for everybody. The tragedy will be if all parties do not learn from these events. Learning is required particularly for: • Central Banks • Supervisors of financial institutions • Investors In learning from the crisis there are two types of learning: (a) what caused the crisis; and (b) how different remedies performed when tried.

Third, financial markets had become irrational in some important respects, and managed by models and quantitative methods at the expense of good judgment. These models lacked transparency, but it was worse than this. The complexity meant that there was a lack of openness and comprehension of the risks that extended beyond a smaller number of specialists to financial managers, executives and regulators in general. The complexity of the new financial products was married with the unwise decision by many banks and securities houses to rely on small groups of specialist risk managers who themselves formed a small fraternity that did not communicate well with those that needed to understand the risks. For many of the new ìstructured productsî you needed advanced – postgraduate - mathematics to understand and analyze the risks. Surely this was unreasonable for even quite talented investment managers. As we saw they could not manage the complexity. This had to come to an end and it has. Fourth, there are fundamental economic issues behind the crisis. (1) First, once financial markets moved away from reliance on banks’ balance sheets to the broad use of securities markets, for example people buying mutual funds instead of keeping funds in banks, banks didn’t have enough of their own money to lend. However the lending didn’t stop. Thus there was a fundamental funding gap. It was filled by three processes, all of which have failed to some degree in this crisis: (a) the global interbank market; (b) securitization of bank assets that they originated; and (c) ongoing confidence in banks such that the high leverage of banks was sustainable. It is this liquidity – funding – gap that is the root of today’s crisis and is a very intractable set of problems to resolve. (2) Secondly, this crisis is a test of the economic relationship between financial markets and the real markets of goods and services. The first full year of the crisis impacted mainly the US housing markets but has now spread virulently to commodity markets and is starting to hit employment and growth. There is no experience with such a crisis of deleveraging and thus how long the impact will last on jobs and growth is difficult to assess.

China
We have many friends with us today from China. So a natural question is how does the credit crisis affect China? Asian banking markets are in better shape but that is not true of Asian equity markets. The risk for Asia is that the crisis will spread to imports and hence export lead economies will suffer. This economic risk is now being priced into Asian equity valuations. Much of the popular discussion of the Chinese economy and Chinese financial system misses what to me is the essential point. Most commentators focus on the high growth rate, the enormous potential and the fact that in terms of gross domestic product China will soon surpass the United States. All of these are true. However to me the important questions for China concern how you manage such a large economy and an economy with such a high growth rate? The Chinese authorities have a challenge given the size of the economy, the geographic reach, imbalances in sectors, products, education, key skills and other such factors. In the banking world the supervisors have a difficult challenge as it is to be expected that with such a high growth rate, bank lending and financial products will not all be successful. Thus Chinese supervisors will always need to be active and risks and bad loans in banks will always seem high, but not necessarily as bad as they look given the growth of the economy, as long as the management and pricing of risk is done appropriately. But this will require careful management. I believe the government fully recognizes these challenges and this is one reason why they have encouraged

joint ventures with minority shareholdings by foreign banks to bring in additional skills. The Chinese authorities and local financial institutions are also devoting a lot of resources to training. I am impressed with what has been achieved and I believe the caution that has been shown by the China Bank Regulatory Commission has been warranted. They must have some satisfaction now, when so many foreign banks and governments were telling them in previous years that they were too cautious and needed to allow western financial wizards to play in Chinese markets. Caution in a regulator is a virtue not a vice. It is important to realize that western countries have been slow to regulate well, and change has been piecemeal and irregular. For example the Bank of England existed for 200 years before they had formal supervisory legislation. The United States took 70 years to change the Glass-Steagall Act. Canada still cannot reconcile global financial markets to provincial regulation. Yet China has managed to bring in financial regulation sufficient to assist the economic powerhouse to grow within 25 years. Regulation and supervision in China are not perfect but neither is it in any Western country. But to do so much in 25-30 years is an enormous achievement. Western countries will probably spend 10 years fixing their financial markets. It is unlikely that they will get it right the first time. For example, one of the challenges that makes US financial regulation so difficult is the political interference. Even the emergency bill introduced by Treasury Secretary Paulson was corrupted by political interference. The original ìTroubled Asset Relief Programmeî was originally 109 pages with 8 pages for changes in the deposit insurance structure. However the Senate added 154 pages of ill considered tax breaks and 184 pages of political pork. The latter included benefiting the rum excise tax affecting Puerto Rico and an exemption from excise tax for toy wooden arrows used by children. The politics of US legislation, financial or otherwise, is enough to cause people to have grave concerns as to the ability of Americans to manage their own economy competently. It has been said that there are two things you do not want to watch being made: sausages and government policy.

Closing Thoughts
So in conclusion, there is nothing truly surprising in this financial crisis. This crisis or a similar one would have happened sooner or later. It highlights what we should have known all along that: (a) Markets are potentially fragile and problems spread rapidly by fear across markets. (These same markets often experienced bubbles built by greed.) (b) Banking is based on confidence which must not be shaken or the system will not work well. (c) Bank regulation and supervision are not well designed. Regulation works well in good times when it is not tested. In good times everyone says what a good job is being done. As you can see that is not a strong recommendation in bad times. (d) There are lessons for international cooperation in financial regulation and supervision, however that is a separate and longer talk. This crisis shall pass, and fortunately Canada is a small country. But perhaps, based upon history, it might take two years or so for the economy to dip fully and then recover modestly, and five years for a reasonable recovery in financial valuations. Meanwhile volatility will remain high. I would be delighted to respond to questions.

About Dr. John C. Pattison
Dr. Pattison has been active in financial services, finance and economic research for almost 40 years. As a faculty member in both economics and business faculties of a major Canadian university, and then as a senior officer of a large international financial institution he has . He has been a director of companies and not for profit organizations in Canada, England, France, Australia and other locations. He has written more than 80 publications that have appeared in Canada, the United States, Switzerland, Germany, Italy, the Netherlands and the United Kingdom. His first book, Financial Markets and Foreign Ownership, was published in 1978. He has appeared before the Standing Committee on Finance, Trade and Economic Affairs of the Canadian House of Commons as well as providing an Expert Paper (with Michele Fratianni) and testifying to the International Financial Institutions Advisory Commission, established by the United States Congress.

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